Question

select all that apply

when a company has both common and preferred stock, its roe must be adjusted by ______ (select all that apply.)

adding the preferred stock balance to total stockholders equity
adding the preferred stock dividends to net income
subtracting the preferred stock balance from total stockholders equity
subtracting preferred stock dividends from net income

Explanation:

Define standard ROE and the effect of preferred stock

When a company has only common stock, Return on Equity (ROE) is calculated as:

$$\text{ROE} = \frac{\text{Net Income}}{\text{Average Total Stockholders' Equity}}$$

However, when preferred stock is present, ROE is calculated from the perspective of the common stockholders (often referred to as Return on Common Equity or ROCE).

Determine the required adjustments

To measure the return specifically available to common shareholders:

1. Numerator adjustment: Preferred dividends must be subtracted from net income to arrive at net income available to common shareholders.
2. Denominator adjustment: The preferred stock balance (carrying value) must be subtracted from total stockholders' equity to arrive at common stockholders' equity.

Evaluate the given options

• Option 1: "adding the preferred stock balance to total stockholders' equity" — Incorrect.
• Option 2: "adding the preferred stock dividends to net income" — Incorrect.
• Option 3: "subtracting the preferred stock balance from total stockholders' equity" — Correct.
• Option 4: "subtracting preferred stock dividends from net income" — Correct.

Answer:

• adding the preferred stock balance to total stockholders' equity
• adding the preferred stock dividends to net income
• subtracting the preferred stock balance from total stockholders' equity (Correct answer)
• subtracting preferred stock dividends from net income (Correct answer)